Big Bank 'Living Wills' Are a Failure — and Point to a Bigger Problem

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Regulators this week rejected, in whole or in part, the “living wills” of seven of the eight largest U.S. banks. Does that suggest that those banks are all still “too big to fail?” I would step back from that. The very process of having banks design living wills, which are roadmaps for their own bankruptcy, suggests they are too big.

For four years, banks with assets above $50 billion have had to detail in granular form — in documents that stretch to 100,000 pages — how they could be unwound if they get into trouble, in a way that doesn’t threaten taxpayer dollars or the greater economy.

We require this of no other business that I know. We don’t fret that the collapse of a successful tech firm like Apple or a large employer like Walmart would take the economy with it. Only banks, largely because of their role in supplying businesses with capital and liquidity, as well as the oversized risks they take as part of their everyday routine, carry this fear. We witnessed the catastrophic effects of such a disaster in 2008.

Other companies, even ones just as big as banks, aren’t put through this ringer. Banks are because of the mindless complexity of the modern financial system. Large financial institutions have thousands of subsidiaries scattered around the world (ones they probably won’t be able to tap in a U.S. bankruptcy scenario), along with significant (and significantly obscure) assets and derivative positions tied up in global markets, to say nothing of the highly leveraged short-term funding that powers their daily operations. Plenty of people I respect find the idea of winding down these firms impossible.

Matt Levine at Bloomberg describes the living will process as less a roadmap for bankruptcy than an exercise to get bank executives thinking, in a detailed and comprehensive fashion, about how their institutions actually work. It’s stunning that any company would need prodding to do that. It’s even more stunning that we allow banks to exist that have to be prodded into such thoughts.

The largest banks have been writing living wills for over four years. In 2014, all of them failed the test. Two years later, the vast majority of the living wills are still deficient. Even Citigroup, whose living will passed, was still told its plan had shortcomings; regulators split on Morgan Stanley and Goldman Sachs, with one regulator finding them credible and one not.

So in four years, virtually all of the biggest banks in America can’t tell an extremely patient regulatory apparatus what to do if they fail. That’s a clear sign of the impossibility of effectively managing these institutions. If you can’t reverse engineer the bankruptcy, you really can’t know the full extent of the firm’s risks or liquidity needs, or how it may react in a crisis (like the looming one in energy debt).

In other words, the very need to devise the living will, not just the failure to deliver a credible one, is itself an indication that these companies are just too big, that the risks of their existence far outweigh whatever benefits they offer (and those are typically overstated). Having big ATM networks are nice, but experts have found consistently that there are no real economies of scale for banks over $100 billion in assets. And they certainly don’t outweigh these tremendous risks.

Fortunately, the failure to design plausible living wills triggers a process by which regulators can break up these behemoths. Section 165(d) of Dodd-Frank states that, if the FDIC and the Fed find the living wills “not credible,” they have the authority to impose higher capital or liquidity requirements, restrict the growth or operations of the company or even force it to divest assets.

However, the Fed and the FDIC interpreted that authority to give the banks a lot of slack — in my view, excessive slack. Banks can repeatedly re-submit living wills to get a passing grade. The 2014 ruling triggered the first re-submission. Now the five banks that failed both the FDIC and the Fed’s tests — JPMorgan Chase, Bank of America, Wells Fargo, Bank of New York Mellon and State Street — have until October to fix their plans again. (Goldman Sachs, Morgan Stanley and Citigroup have until July 2017). Only then will penalties be considered, and even then just the higher capital or liquidity requirements. Restrictions on growth or divestitures wouldn’t come until two years later, per a clock written into Dodd-Frank. Banks can re-submit and re-re-submit this entire time.

This means that the public will wait as much as six years while banks that cannot figure out their own bankruptcy plans continue in their same bloated state. As a matter of systemic risk, this makes no sense, absent some compelling reason for banks to stay that large.

Tellingly, stock prices in all these firms went up on Wednesday, when the living will announcement was made. There are two reasons for this. First, Citigroup was able to get a passing grade on its living will, showing that the regulators will wave these through if they get what they want. Second, investors simply don’t believe that the Fed and the FDIC will pull the trigger.

Moving battleships is difficult, and it’s good news that the regulators are at least taking the living will process somewhat seriously. They were pushed into doing that by reformers, most notably through Sen. Elizabeth Warren’s evisceration of Janet Yellen over this in a public hearing. But it’s really not enough.

Dodd-Frank could have been much simpler in this regard, structurally attacking size and complexity rather than creating a discretionary, drawn-out, overly technical process. A system of escalating capital requirements, so banks have to pay for their own mistakes, or a cap on bank size, to prevent their economic and political leverage and the maddening complexity of their global operations, would have been preferable.

This is critical because we’ve already seen the stakes. Warren corrected the record this week, which had been sullied by the likes of Paul Krugman, that big banks had nothing to do with the 2008 crisis. Their packaging of loans into securities, and funding the subprime lenders who issued them, drove the very heart of the crisis. We didn’t punish that largely illegal behavior, instead opting for a flood of settlements.

At no time during the crisis, or in the many years since, has anyone made a legitimate case for why we should put up with the threat of another implosion. What economic value do giant mega-banks offer that we have to force them to design their own bankruptcy? What would we lose if they were all cut down to a size where they wouldn’t have to be browbeaten into understanding their own businesses?

David Dayen has been writing about politics since 2004, first as a blogger and then as a freelance journalist. He is a contributing writer to Salon.com, and also writes for The New Republic, The American Prospect, The Guardian (UK), Politico, The Huffington Post, Alternet, and more.